Tuesday, June 14, 2011

Earnings Quality check - on India Nifty stocks - Does your portfolio / mutual fund has the `next Satyam` ?( this post is updated with additional comments in the end)

Introducing a new series on Earnings Quality check – also called as
SSEXI – Saanp aur Seedi Earnings Xittiness Index.

So why name it as SSEXI not EQI ( Earnings Quality Index) ?

My goal is to not to establish a hall of
fame but a hall of shame. For the former, there are numerous ratings such as
ET,BS,BT ( Economic Times, Business Standard and Business Today).

I was bit frustrated by the lack of availability of decent earnings quality analysis on Indian firms by the reputed big brokers equity research desks. So decided to do this research.

Please let me know your top pick for this rating ( i.e worst
quality of earnings) by posting your comment. I have also enabled comments
posting as “Anonymous” i.e one can post a comment without the need to log into
your email account.

Also let me know , if you have any stock that you want this
check to be done. I cant promise it will be done but within my time constraints,
I will try my best to close it. My next
objective is to do this similar SSEXI rating on my potential list of
multi-baggers ( ~ Top 40 stocks)

Approach - is quite
simple . It involves the past 4 years trend and ratios within same sector.The ratio would be reported
P&L Net Income ( or PAT Profit After Tax) to cash based profit or CFO – Cash Flow from Operations. This can be nicknamed
as NICFOR – Net Income to CFO Ratio. Similarly other ratio that could be compared is comparing reported
EBITDA to cash EBITDA or CFO before cash interest and cash taxes paid.
The most used valuation metric is PE ratio. But `E` is heavily related to accounting standards adopted by the management and involves accrual component also. So my approach is to find out the cash based earnings (i.e CFO from the cash flow statement ) to arrive at the actual PE ratio ( based on cash earnings).

Here is the rationale of using CFO as better valuation
indicator. There are generally three
reasons for which Net Income and CFO will differ.

Non Cash charges such as depreciation - reduces Net Income. This will result in CFO
being higher than Net Income, other things remaining the same. Thus CFO will be
a better metric to judge the cash flows available to a firm

Working capital changes – such as increasing
Account Receivable will reduce CFO as compared to Net Income. Thus CFO reflects
better quality of revenues and working capital management of the firm. Some high working capital intensive business such
as Infra/ real estate might have a negative CFO also. This combined with a reported
positive Net Income will result in a negative NICFO ratio.

Other income
- such as investment income, sale of
long term investments are added to the reported P&L Net Income. But in the cash flow statement,these
items are added under CFI ( Cash flow from Investments) so the result is that CFO would be lesser than Net
Income. Thus CFO would be a better indicator for valuation. This is fair because business
should be valued only on recurring `core` earnings of the business.

I had to make slight adjustments for Indian firms. Under
Indian Accounting standards, interest paid is classified as CFF – Cash flow
from Financing activities. So while comparing NICFOR for Indian firms, I have taken the interest paid from CFF and reduced it from CFO to arrive at an adjusted CFO
that matches Net Income. (Under US GAAP interest paid is classified under CFO and under
IFRS , firm has option to classify as under CFI or CFO)

Similarly I had to make some adjustments if there was a
significant one-time other income added to the Net income.

This NICFOR trend can be very useful to identify

Accounting aggressiveness / conservativeness used by the management. This can
also be compared over the years and within the same sector.

Arriving at truer and better valuation / PE ratio -Can be used as a discount / multiplying factor to
arrive at true valuation ratio that can be used to give a better
overweight/underweight rating. For Eg. if a firm has latest PE of 10x and NICFOR
of 1.5x this means that the actual PE is
15x ( reported PE x NICFOR) . Similarly if the same firm had a NICFOR of 0.7x
that means actual PE is 7x and not 10x.

Potential earnings manipulation by management.
Management has various reasons for earnings manipulation. Some are

d.To meet debt covenants and avoid lower debt rating. Also over $7 Bn of FCCB`s ( Foreign currency convertible bond) will be maturing in the next 2 years and firms that have issues these FCCB`s would like to see their share price goes up and above the conversion price so that the debt will get converted to equity.

From the past accounting scandals,
the most reliable alarming signs are usually comparing CFO to Net Income. Other
ratios such as debt to equity ratio have not at all shown any early signs.
Enron ,for example had debt to equity ratio of 0.9 but its CFO was consistently
negative as compared to its reported Net Income.( It showed actual negative CFO as positive by reporting `CFO before working capital charges` separately.)

I have done a study of ~ 25 NIFTY
companies (comprising ~ 61% of Market cap of NIFTY or ~ $0.8 Trillion. (
See the chart below at the end. Click to zoom) .Some other points to note:

1.All accounts are as per Indian Accounting
Standards

2.I have taken Consolidated Financial Statements
only.

3.These ratios only gives an indication of
earnings quality or accounting aggressiveness and these ratios do not imply higher upsides in the
stock, as the earnings /CFO growth is not compared here. Will come up with an update
later .Stay tuned / subscribe
to this blog to get latest update via email. ( click on the top right hand side)

4.Most Indian firms have not yet released their FY11
Annual report. Will come up with an update later. Stay tuned / subscribe to this blog to get
latest update via email. ( click on the top right hand side)

5.* Only for Satyam – F.Y is FY`10 to FY`06.

6.# for
L&T – in FY10 I have removed the one time income from Net Income to adjust
for stake sale of Ultratech Cement and Bangalore airport.

These are the companies I have studied :

IT Pack - SATYAM* ,TCS,INFOSYS,WIPRO,

Oil and gas –RIL,GAIL,ONGC

Capital Goods -L&T# ,BHEL

Auto -M&M,TATA MOTORS,MARUTI SUZUKI,HERO HONDA,BAJAJ AUTO

Power -NTPC

Telecom - BHARTI AIRTEL

Mining – STERLITE,COAL INDIA

Steel - TATA STEEL,SAIL,JSPL

FMCG –HLL,ITC

Cement - ACC

Real Estate – DLF ,JP ASSOCIATES

Here is the table ( click to zoom)

Here is the same chart with a heatmap. If ratio is more than
1.1 or reported P&L number is 10% higher than indicated by the cash flow,
then it is highlighted as RED.

Brief Ending Comments on the chart

Satyam was a clear outlier with reported P&L numbers
double the cash flow numbers. ( i.e actual PE of Satyam was double / 20x vs then reported PE of 10x. Similarly P&L EBITDA to Cash EBIDTA ratio was 3x-4x). Even even big players such as L&T, Aberdeen Fund, Fidelity,J P Morgan, Morgan Stanley,,LIC, ICICI Pru,Singapore Sovereign fund were caught in this value trap. Yes , it is hard to tell if outright fraud is committed or not just by this ratio but at least it flags off valuation concerns and a fundamental value driven investor would have avoided the Satyam `value trap`. As per the table, for Satyam , the xit was actually hitting the fan. And had R Raju
not sent the letter of acceptance of the fraud I doubt if this would
have been unraveled. Cases such as Satyam only shows the weakness of the system
in catching such manipulation. Also had the cash from Satyam been put into a
more liquid asset ( say Gold ETF`s vs real estate Land) , Raju could have
easily raised liquidity and announce a big buyback at a huge premium. Even many
IT majors such as IBM was also in the
fray to acquire Satyam. And had such a deal been pulled off then many of us would never have known this.

Big drawback in India is that
Balance Sheet and Cash Flow Statement is not disclosed quarterly. And recently
SEBI required firms to report Balance Sheet every 6 months. Maybe this drawback
one characteristic of an emerging market.

Till date ,out of this study
sample of 25 NIFTY firms that comprise of 61% of total market cap of NIFTY,
just four firms have released their full FY 11 financial statements –
INFY,TCS,ACC and RIL. Will update this again after a month or so.Stay tuned to this site.

IT Pack -Surprisingly for latest FY11 ending in Mar 2011,INFY and TCS have shown
their NICFO ratios hitting the highest level in the last 4 years. This might indicate the
pressure by management to meet the huge street expectations. CFO for TCS and
INFY declined by -10% and -23%
respectively vs their reported earnings growth of +30% and +10% respectively. Thus as compared to the reported PE of 25x of both TCS and INFY, the actual PE ( based on CFO) is actually 35x. ( reported PE x NICFOR of 1.4x). If in FY11 this is the standard set by IT firms then I believe it would be very fair to assume that other sectors would be worse/ similar.

These
ratios should generally be stable over the years without big variations. Any big variations -both
on higher or lower side need to be examined more closely. A negative ratio ( in
most cases) would be a result of positive Net Income and Negative CFO.

Again
I repeat – These ratings / ratios are just indicative of P&L based earnings
vs cash based and higher ratios cannot be assumed to imply a fraud. However,
higher ratios would require closer examination. And most importantly , one
should be extra careful of firms that have positive Net Income with Negative
CFO ( i.e negative NICFOR).These kind of firms
would definitely deserve a lower valuation rating. Similarly a lower
ratio does not imply higher upside as upside depends on fair value vs current
price and future earnings growth and this study doesn’t cover cash flow /
earnings growth. I will explore it
later. Stay in touch with this blog to be the first one to know.

One could make a hypothesis that
in general PSU stocks ( Public Sector) would have lower ratios as unlike
private sector management doesn’t own significant stock in the firm. But again
if a PSU is looking to raise equity via FPO/IPO the tendency to adopt
aggressive accounting standards will increase.

Here is the sector wise summary of the findings ( the given tables)

IT – For FY`11 ,TCS and INFY both
seem to be a race to the bottom in terms of earnings quality. From past 4 years
record ,it seems Wipro earnings has been consistently of lower quality.

Oil & Gas – RIL `s earnings
quality has been consistently poor but the latest FY`11 shows a sharp drop in
ratio – a 55% drop in NICFOR from 1.5 to 0.6. Effective tax rate ( based on
Cash tax / CFO before Interest and taxes) has also been low at 11%.It again
raises more questions than answers. PSU`s GAIL and ONGC score way higher.

Capital Goods – L&T earnings
has been consistently poor and has been on a steady downhill since FY`07 when
the NICFOR was 1.0. For two years, CFO was in fact negative. BHEL has been
consistently better for last 4 years except for FY`10 where it took a change
for the worse matching with L&T.

Coal India – steady. Only slight
increase in FY`10 most probably due to planned IPO. FY`09 ratios dipped ( to as
low as 0.2) as P&L Net Income was abnormally down due to salary revision.

Banks are excluded for this study.
But my view is that the earnings quality of banks would always be inferior to
other businesses/sectors. Unlike other businesses, Banks first `loan` their product/ service ( loan) and then
start recognizing revenue ( interest income) immediately as the customer starts
paying EMI`s and loan defaults generally doesn’t happen within the first/second year of the loan. It happens after the
initial 20%-30% of the loan tenure. And NPA recognition standards in India are
very subjective and not stringent. Loan collateral /security / personal
guarantee also doesn’t have any meaning as even if the borrower defaults, in
most cases the collateral is not easy to liquidate soon. Some Indian private
banks also show their low default rates over the years but this doesn’t make
sense with India macro of low per capita income of $ 1,000 and low transparency
in many sectors. I.e not only ability to pay factor is important but one also
need to factor in willingness to pay. Micro finance is a good case study.

This study throws up many other
areas to explore and hope to do some in near future. Other areas to explore
from here :